​​​The short term Shanghai Interbank Offered Rate, or SHIBOR for short, has exploded higher in recent days. In the process, the interest rate curve has sharply inverted in December 2013 to renormalize after. But it brang fear into the China s financial markets...​
​The People's Bank of China (PBOC) in recent days has refused to inject cash into the market on a large scale, even as money rates rose steadily from recent lows hit in after the June squeeze. ​​​Traders interpreted the central bank's non enough-action as a signal that authorities plan to keep liquidity relatively tight and in fact can be a tightening.

​​​The People's Bank of China has made an emergency injection of liquidity into the country's financial system finally in December after money market rates started to spike again due to lack of action by the PBOC earlier and increasing demand for money because banks need it for year-end regulatory requirements. The one month SHIBOR rate fell 11 bps to 6.83% after jumping more than 37 bps since Jan 13, helping to drag the Shanghai Composite down again today.​Chinese shares suffer worst run for 19 years as cash tightens. The People's Bank of China (PBOC) did not conduct any open
market operations this week for the third straight week.
The decision not to inject cash into markets continues
a tight stance that observers say is intended to curb
off-balance-sheet lending, which is often funded with interbank
borrowing.

​​China s PBOC signalled they are considering mild
tightening to get rising property prices and inflation under
control.
The PBOC abstained from injecting cash for the third consecutive
session, resulting in a net drain and alarming some traders.

First fear appeared this year when Investors have been jittery about the impact that the FED Tapering may have on emerging markets.​​ But the first impact of it have been the rise in real interest rates in the Asians countries and the US as we will see the kind of dominos effect on the Emerging Markets. Since then, risk have abated but only delayed til next year as Fed s Yellen nomination take office.

Market participants ​​are divided on the significance of this week's
phenomenon, with some arguing that it marks a first step toward
making cash more expensive over the long term, following years
of easy money in the aftermath of the global financial crisis.
Just wondering as much as it can be a Stealth Tightening ?

Volatility

​​In that kind of environment, where the global capital flows tend to be back to the US when real rates are rising, we observe the rise in volatility in Emerging Markets stocks ( China ETF ) as shown by the chart below...

Observe the decorrelation lately, volatility increasing on the China ETF when we had fresh new highs on the SP500...​​

​​If there is some global capital outflows from emerging markets to the US, it means that portfolio managers are selling EM currencies
​ (​we took the CEW ETF for emerging currencies and China iShares ETF ( FXI ) for emerging stocks in China) to be back in the US Dollar as shown by the chart below... The first wave of sell off happened when the first tapering fears appeared in May 2013. A complete reversal was made at the Fed s meeting in September.

We can observe that for now, only FXI started to correct in price and the emerging currencies continue to weaken...

​​That correction in prices is normal after a very strong performance. But illiquidity of those emerging markets can create a turmoil and that
​drip-drip of currency weakness can become a flood and trigger more flows. It is what happened in 1997, what has been called later the Asian Financial Crisis.

But two very crucial factor is different than 1997 for those emerging countries; Japan s Abenomics with a huge devaluation of the Yen and the level of debt is even bigger than in 1997 can create that spill over effect and make the situation even more sensitive.

Conclusion
​
So what’s the significance of the rising liquidity squeeze of China – the effect of risk off since the tapering have been discussed ?

Too few investors are aware of the problems that may be piling up. While interest rates remain low the leverage increase continues. With the FED starting the Tapering process on Dec 18 and with the Bank of Japan joining the western central banks in aggressive monetary easing, there’s little chance of any early change in the financial climate.

It will be crucial to follow the emerging markets capitals flows and currencies to see if it is a temporary situation or can turn into a flight to liquidity as in 1997.

From the time being, I will avoid China s stocks as long as the PBOC is considering hiking rates​​ and technicals are not in favor...